In late November and early December, Wall Street’s market strategists observe a time-honored holiday ritual: predicting where the S&P 500 will finish in the new year. Traditionally, these forecasters mainly form a herd of cockeyed bulls even when fundamentals suggest caution, as when shares show clear signs of being overpriced versus historical benchmarks. Though stocks looked extremely expensive at the close of 2020, most of the banks forecast double-digit gains for last year. J.P. Morgan was most optimistic at 17%, followed by Goldman Sachs (14%), and UBS (11%). Bank of America and Citigroup bucked the mainstream by warning of froth and predicting a minimal rise, but none of the Street’s stalwarts foresaw an outright decline.
Of course, investors swamped even the bluebird calls by lifting the S&P 500 by 27.2% last year to close at 4766. That blowout took big-caps into territory that by reliable yardsticks makes them pricier than at any time since the tech bubble of 1998 to 2000.
Nevertheless, you’d think that the banks would find ways to tout 2022 as a winner. I was expecting the usual practice of spotlighting special positives that promise to surmount super-high valuations and propel the S&P to still another double-digit performance. Amazingly, that’s not the case. At year-end, Wall Street issued guidance that’s both ultra-modest in numbers and rife with warnings. Memo to investors: If the ultimate hype factory for stocks sees big-caps practically flatlining over the next 12 months, you might want to add a steep discount.
Of course, even the most reliable market metrics don’t tell you much if anything about how shares will fare in any period as short as a year. Such phenomena as the meme craze and breakneck momentum that’s driven shares of EV makers and tech darlings to incredible valuations render short-term forecasts highly unreliable. In the dotcom frenzy, the S&P looked dangerously overvalued in mid-1997, yet kept soaring for three more years before the inevitable collapse. This time, Wall Street is sending us a warning wink. The banks’ faint praise for 2022, the reasons they are citing for a “weak” year ahead, are durable roadblocks that point well beyond the next 12 months to poor returns stretching far into the future.
Wall Street is predicting puny gains for 2022
Compared with the 2021 crop, the bank’s S&P 500 targets for this year are a story of lower highs and lower lows. Among nine large players that provided year-end estimates for 2022, the most favorable forecast came from Credit Suisse. It predicted a close of 5100, garnering a gain of 9.1% for the 500, well below the 2021 “high” of 17% posited by J.P. Morgan. In second place sat Goldman at 7%, followed by J.P. Morgan and RBC (both 6%), Deutsche Bank (4.9%), and Citi (2.8%). The biggest surprises were the flat and negative outlooks. Barclays sees an increase of just 0.7%, while Bank of America predicts a decline of 3.5%. Most bearish is Morgan Stanley, reckoning that the S&P will drop 7.7% by New Year’s Eve of 2022.
The average for the nine targets is a rise of 2.8%. The S&P is also delivering 1.3% in dividends. Add that to a 2.8% capital gain, and Wall Street writ large foresees a total return of 4.1% for 2022. In November, the consumer price index raced at 6.8%, and even if inflation slows to the 2.6% forecast by the Fed, investors would pocket only puny “real” gains if the banks’ suddenly chastened experts are right.
But the forces that make Wall Street mildly negative on 2022 aren’t going away, and they’re a lot stronger than the bright-side-seeking sages acknowledge. Those headwinds may not even make their mark in the next 12 months, but they will weigh heavily on prices for years to come. The fundamentals look bad for future returns. Here are the five reasons stocks will do poorly over a long horizon.
Reason 1: Valuations are dangerously stretched
To assess how stretched equities have become, it’s necessary to examine not just how much prices have risen relative to earnings, but whether today’s gigantic profits are sustainable. If they’re not, the official price/earnings multiple (P/E) is vastly understating how expensive equities really are.
As of year-end, the S&P 500’s P/E, based on earnings per share (EPS) through Q3 of last year, stood at 27.2. That’s by far the highest number since the tech bubble two decades ago, excluding a couple of quarters in 2000 when collapsing profits inflated multiples. Wall Street’s enthusiasts claim that today’s P/E based on future earnings remains in the reasonable range because profits will keep surging. But they’re wrong. In reality, corporate profits are at bubble highs that leave no room for expansion. Earnings growth can’t bail out today’s huge valuations.
In the fourth quarter of 2019, S&P 500 profits hit an all-time high of $139.47. Then in the COVID comeback, big-cap companies went from strongly to sumptuously profitable. Generous government outlays to combat the crisis handed families trillions in cash that they lavished on stay-at-home products and services from computer gear to remodeling their ranch or colonial. Starting in Q2 of last year, earnings went on a tear not seen in decades, jumping to $175 in Q3 of last year, dwarfing the summit set just 15 months earlier by 25%. The problem: Operating margins––and hence earnings––are hitting a wall. In Q3 of 2021, they reached 13.2%, compared with 10.6% in Q4 of 2019 when the S&P achieved that pre-COVID peak. Right now, the share of sales going to operating income is 40% higher than the average over the past 12 years.
Today, rising labor costs are shrinking that bulge. Chris Brightman, CEO and chief investment officer at Research Affiliates, a firm that oversees strategies for $166 billion in mutual funds and ETFs, tells Fortune that the era of fast-rising profits is over. He predicts that EPS is likely to go sideways, simply matching inflation, through much of this decade.
Reason 2: The Shiller P/E is flashing red
The best metric for determining whether future returns will be rich or poor is where you start. If overall prices are cheap, you get a lot of profits for each dollar you’re paying––the box is packed with Rice Krispies––and you’re likely to do great. If your stocks are netting fewer bucks now, the bottom line had better grow fast to hand you double-digit gains.
But today’s profits are so immense they have nowhere to go but down or sideways. A valuable metric demonstrates that if we take the untenable spike out of EPS, we’re left with “normalized” profits that are much lower. That makes the dollars you’re paying for each share, versus the dollars you can count on in profits, much higher than they appear. The yardstick is the cyclically adjusted price/earnings ratio (CAPE) developed by Yale economist and Nobel laureate Robert Shiller. The CAPE removes distortions from temporary spikes and valleys in profits by averaging EPS over the previous 10 years, adjusted for inflation. Indeed, the Shiller P/E ranks among the most powerful predictors of what stocks will deliver over the following decade.
Today, the CAPE registers 40. It’s been that high in only one period since 1877, for 21 months during the dotcom frenzy lasting from the start of 1998 to late 2000. Over the next three years, the index dropped 43%; it took 13 years for the S&P to regain the levels late in the period where the Shiller P/E exceeded 40.
Reason 3: ‘Real’ rates will rise, crushing multiples
It’s the Fed’s recent pledge to raise rates next year that most bothers Wall Street. In explaining their 2022 targets, the banks acknowledge that the Fed’s shift will pressure today’s super-high P/Es. It’s a major factor in Savita Subramanian of BofA’s forecast that the S&P will shed 3.5% this year. Since volatile equities compete with risk-free bonds, the less Treasuries are yielding the more investors will pay for their chancier rival. Warren Buffett highlights the drop in the 10-year Treasury yield from over 13% in 1984 to 4% in the mid-2000s as the top factor driving the multiyear bull market. The Fed has served up an even stronger tonic in recent years that’s kept the party roaring.
What matters most isn’t the “nominal” rate you see on your computer screen, but the “real” rate, adjusted for inflation. As long as price increases remain moderate, companies can raise prices to stay even; indeed, the increases in what companies charge for cars, iPhones, and appliances are what generate inflation. Falling real rates mean that bonds are offering a lower and lower premium, or cushion, over inflation, while companies are keeping up. Bonds get less attractive, and money flows into stocks, swelling P/Es. The U.S. has seldom experienced a period of real rates this low. From 2014 to late 2018, the inflation-adjusted yield the 10-year Treasury (long bond) floated mainly between 0.5% and 1.0%. Since then it’s fallen to a negative 1%. That descent has been the principal lever in hiking the official P/E from the low 20s to today’s 27, and the CAPE from the mid-20s to 40.
In its November meeting, the Fed signaled moves that will raise both short- and long-term rates. The majority of Fed members now believe that the central bank will increase the overnight rate at which financial institutions lend to one another three times in this year and next, from almost zero today to an estimated 1% in 2022 and 1.75% in 2023. Since the Fed funds rate exerts a gravitational pull on prices of longer-term bonds, their rates, which move in the opposite direction, will rise. The Fed will augment that pressure by ending its massive purchases on Treasuries maturing in five years or more in March; the program that’s greatly contributed to depressing yields will end.
How high are “real” rates likely to go? In its July economic forecast, the Congressional Budget Office viewed the inflation-adjusted yield on the 10-year hitting zero in 2022 and 2023, and reaching over 1% later in the decade. But that forecast came before the the Fed’s big move. It isn’t clear how much the Fed’s new strategy will lift real rates, but they’re likely to go higher, quicker than the CBO posited last summer. A swing from minus 1% to a positive 1% by early 2023 would seem plausible. By my reckoning, a shift of 1% to a real rate of 0 alone would hammer P/Es and prices by around 20%.
Reason 4 (maybe): Persistent inflation could make holding stocks riskier
Here’s one that hinges on the famous question of whether the inflation surge is temporary or durable. The Fed predicts that big monthly price increases will return to the 2% or 2.5% range once blocked supply chains are operating smoothly. But if the jackrabbit jumps we’re seeing continue, holding stocks will get a lot riskier. Companies won’t know what they will be paying workers or suppliers next year, making them unsure how much to raise prices, and risk falling sales, today. In addition, surging consumer prices raise the threat that the Fed will jack up rates to tame inflation, causing a downturn that will pound profits. Hence, entrenched inflation would increase what’s called the “equity risk premium” or ERP. That’s the margin investors demand over and above the yield on safe government bonds. When uncertainty rises, so does the equity risk premium.
The ERP operates like the real rate; the higher it goes, the more pressure it puts on multiples. We know the former is going up. Add big inflation to the mix, and you get a devastating one-two punch.
Reason 5: A handful of wildly expensive stocks are dominating the S&P 500 as never before
At the end of 2018, the five stocks boasting the largest market caps were Microsoft, Apple, Amazon, Alphabet and Berkshire Hathaway. Combined, they accounted for 15.5% of the 500’s total value of $22.4 trillion. By the close of 2021, the list hadn’t changed much: The four tech titans still occupied the top slots, and newcomer Tesla replaced Berkshire at five. But now, the top 5 tally to almost 24% of the index’s total cap of $43 trillion. As the values of the newly minted trillion-dollar club grew much faster than the overall S&P, they mushroomed into an oversize share of the index. In turn, that trend made the S&P much more expensive. The reason: The top five in combination are selling at a P/E that’s grown enormously over the past three years.
At an almost $3 trillion valuation, Apple is selling at a P/E of 32, more than twice its multiple in late 2018. Amazon sports a P/E of 67, Microsoft 37, and Tesla a Brobdingnagian 391. The only member with a near-market number is Alphabet at 28. All told, the five generated $263 billion in net income in their last four quarters, but are selling in total for $10.1 trillion. If you considered them as one big company called the Trillion Club Inc., their multiple would be 38. And those big earnings may not have legs given the huge, possibly ephemeral boost to the club from the stay-at-home economy.
Since investors are counting on big earnings increases from the likes of Amazon and Tesla, as well as the same from scores of high-fliers from Nvidia to Netflix, to justify their huge valuations, rising rates will hit these stocks disproportionately hard. That’s because earnings that arrive in the future are worth less today because while they are waiting for the big profits to arrive––and wondering if it will happen––investors will have the option of buying bonds that offer much better yields than today. Put simply, investors who own an S&P index fund or diversified portfolio reflecting the overall index are way overweight in expensive tech stocks and maybe-superstars such as Tesla. Instead of continuing to gorge on the names that have thrived, this is the moment for embracing the overlooked and unglamorous.
The S&P still offers good buys
While Wall Street is predicting slightly positive gains in 2022, and anything could happen in a 12-month span, here’s the real message that the banks only hint at: The multiyear outlook for big-caps is poor.
Research Affiliates predicts that over the next decade, S&P 500 earnings per share will grow at just 3.5% a year, and that you’ll get another 1.3% in dividends. That scenario wouldn’t be so bad if multiples remained at the current, towering 27. But Research Affiliates predicts P/Es will shrink dramatically, leaving investors with a total annual return of just 1.6%. Since the markets are predicting 2.6% inflation through the 2020s, investors would witness what their holdings could buy in goods and services sliding with each passing year.
The S&P still offers good deals. But they are virtually all in unloved, beaten-down sectors that the recent boom missed. BofA recommends three sectors featuring low P/Es, high dividends, and stable earnings: energy, health care, and banks. The financials, for example, benefit from rising rates because they swell the spread between what they pay for deposits and charge for loans. Health care and energy should benefit from strong pricing power.
Wall Street’s dim view of the markets for this year is a tell, signaling that even the cheerleaders believe the craziness has gone on too long. You can’t start with dizzyingly high prices and expect to still make good money.
It’s time to take the hint.
